A strong economic recovery and continued reflationary bias from the Federal Reserve could push long-dated yields higher on US Treasuries, says Sunil Krishnan.
Our thinking on equities remains broadly unchanged. Since March 2021, investor consensus has broadly caught up with our positive view on the economic forecasts for the US and Asia. However, we remain more optimistic than most market participants on other regions, such as Europe.
We also continue to see more upside risk potential than the consensus. While investors no longer seem to be underestimating the central case for US growth, they may still be misjudging how strong this could be. Households and firms have built up large savings and may be willing to increase spending on items like holidays and restaurants as the economy reopens, without necessarily foregoing the things they were spending on during lockdowns.1
To put this into context, investors have started debating the question of peak growth – the time when the economy continues growing but growth stops accelerating. It can trigger some volatility in the markets and lead investors to be more cautious. But the current consensus estimates GDP growth in the US to slow down from roughly nine per cent in the second quarter to seven per cent in the third and five in the fourth.2
By any historical standards, this is not what we would expect peak growth to look like. In the past, it would have typically slowed from around three per cent to one per cent; so this time is different, and investors may not be fully appreciating it. That is one reason we continue to favour risk assets and have not changed our positioning.
Going short on duration
Where we have revised our thinking is on government bond duration. Until recently, we were neutral, as reflationary forces and loose fiscal policy cancelled out the attractiveness of diversification and bonds’ carry profile. Even though we held a strong reflationary view from an economic perspective, the investment case was not compelling.3
However, the period since March has seen a material rally in government bond markets, with 30-year US Treasury yields having peaked on March 18 at almost 2.45 per cent, falling to just over 2.04 per cent on July 2 – a 40 basis-point rally.4
This removes some of the concerns we held earlier, such as the carry from an excessively steep curve at the long end of the market. Similarly, some of our indicators earlier in the year suggested short positioning was quite extreme, but the substantial rally is likely to have forced a number of investors out of their short positions. The positioning is no longer as crowded as it was in March.
Payroll numbers are misleading
The idea economies may not be as strong as they look has been one challenge to the investment case for being short on duration. It could be argued labour market outcomes in the US, for example in terms of payroll figures, have not been as strong as they were at the highest point of the recovery.
Many industries have been disrupted, as have certain geographic areas
However, this does not seem particularly indicative of a drop in demand from companies for workers, but rather suggests some mismatches in terms of skills and geographies. Many industries have been disrupted, as have certain geographic areas with, for example, fewer hospitality jobs or retail jobs in city centres. Though it will take time for the labour market to adjust, companies are still looking to hire.
Unemployment benefits also remain supportive. Some Federal Reserve commentators have begun talking about the expiry of some of those enhanced provisions, and when schools go back in September, people may revisit their willingness to work. Therefore, while the hiring figures haven't always met expectations over the last couple of months, there may be some artificial – and temporary – reasons behind them.
The other potential challenge to the investment thesis was the change in the dots – the voting members’ projections about where they think the funds rate could go – announced at the last Federal Open Market Committee (FOMC) meeting. These went from no rate hikes expected in 2023, as of the March 2021 FOMC meeting, to two rate hikes in 2023, as of June.5,6
Markets were implying a gentle move in this direction, but with possibly one hike rather than two. Since then, a couple of Federal Reserve speakers have also said the conditions for raising interest rates could emerge in 2022.7,8 That has led investors to think the central bank may move quicker than previously thought to stamp down on inflation if it emerges, which could justify a reluctance to hold short positions on duration.
The reflationary bias gives a positive skew to the potential outcomes for rates in the Treasury curve
Again, an important element of context is that, if it followed historical norms in reacting to the current growth and inflation numbers, the Federal Reserve would be tightening rates now rather than potentially in 18 months’ time. That is a crucial change that investors may be missing and reflects a reflationary bias. Added to our view growth could be stronger than markets seem to expect, it gives a positive skew to the potential outcomes for rates in the Treasury curve.
In addition, the more the Federal Reserve is seen to err on the side of caution and let the economy run hotter, the more the sense of it being behind the curve will appear at the long end of the Treasury market. Long-dated, 20 to 30-year yields could well be pushed higher because, ultimately, they are not driven as much by where rates are today as by what investors think must happen. There is a reasonable case that the longer the Federal Reserve waits to raise rates, the more it will eventually need to do so.
For those reasons, we have taken a short duration position in our portfolios through 30-year US Treasuries. Shorter-term moves will probably remain quite dependent on the next Federal Reserve speech or FOMC minutes but, in the longer term, the US economy will continue to recover, the central bank will not be quick to step on the brakes, and private and public sector spending will bring continued support.
We are still looking at a substantial expansion in public spending
On the public sector side, for example, the news remains broadly in line with expectations. The Biden administration may not manage to pass a bipartisan infrastructure spending bill, but it is not ‘bipartisan or nothing’. If it must, the administration will proceed with only the Democrat votes, and we are still looking at a substantial expansion in public spending at a time when private spending is likely to recover as well.
From a portfolio construction perspective, it is important to think about the interaction between the government bond market and our equity and credit positions.
Taking the long view, we believe the Federal Reserve will remain supportive of the economic recovery, despite all the recent market debate, which remains positive for equities.
It is important to avoid taking too much risk in any single area
Meanwhile, our view on credit is unchanged, which is that spreads do not currently offer an attractive risk-reward balance. While the asset class will likely perform well in our central macroeconomic scenario, being underweight can prove a useful hedge if things go wrong, as spreads could then widen significantly.
However, if US monetary policy stays relatively easy, pushing up longer-dated rates, that could coincide with a rising equity market and strong corporate profitability. It is therefore important to size positions appropriately and avoid taking too much risk in any single area.